World economy: EIU global forecast - The global economy is in a sweet spot

As 2017 has progressed it has become clear that the global economy is strengthening. Three interest-rate rises in the past eight months by the Federal Reserve (Fed, the US central bank), faster inflation in major economies, higher manufacturing purchasing managers' indices and falling unemployment rates in the developed world are all indicators of a likely acceleration in economic growth in 2017. The big concerns about the global economy in recent years—falling commodity prices, deflation, negative government bond yields and overly restrictive fiscal policies—have all become less apparent. Consequently, The Economist Intelligence Unit expects the world economy to expand by 2.8% in 2017, compared with a lacklustre 2.3% in 2016.

There are, nevertheless, caveats to this positive story. The world's leading economies are at very different points of their business cycles, meaning that the current pace of growth is unlikely to last for long. We consider China to be the furthest through its expansion phase: there is evidence of capacity constraints in some sectors, and the government is tightening monetary policy through a gradual curbing of credit growth. In the US, the Fed is accelerating the pace of its interest-rate increases to combat an expectation of faster inflation and wage growth. The expansion in Europe is less well advanced. Although we have again revised our 2017 GDP growth forecast for the euro zone this month, to 2% from 1.9%, the regional economy is still in recovery mode. Unemployment in the euro zone is at its lowest since early 2009 but remains high compared with the rest of the developed world (and compared with levels before the global financial crisis), and there is little pressure on wages. Deflation is still a cause for concern in Japan, and, among emerging markets, Brazil and Russia are are only just emerging from recession. This lack of synchronicity in the global economy will prevent a surge in growth or major upward pressure on commodity prices. However, because the pace of growth is gradual, the global economy is able to expand without stoking inflation and thus drawing a major policy response from central banks. A decade on from the financial crisis, the global economy is finally in a sweet spot, albeit one that will prove short-lived.

Among the consequences of the strengthening economic outlook are rising bond yields. Bond yields in the US and other developed markets bottomed out in mid‑2016 and were given a shot in the arm by the election of Donald Trump at the end of the year. As businesses lost confidence in Mr Trump's ability to pass pro-growth policies, yields slipped in the first half of 2017. A speech in June by Mario Draghi, the president of the European Central Bank (ECB), in which he suggested that "deflationary forces" had been replaced by reflationary ones, jolted financial markets and pushed up bond yields by as much as 25 basis points in some euro zone economies. Alongside this, the Bank of Canada raised its policy interest rate for the first time since 2010 in June, and the Bank of England (BoE, the central bank) has struck a more hawkish tone.

However, we do not believe that a concerted move towards higher interest rates among developed economies is imminent. The BoE is unlikely to raise rates until 2021. The ECB may wait even longer, after beginning to taper its quantitative easing programme in 2018. Monetary tightening in Canada will be gradual. The Fed is proceeding gradually in comparison with previous cycles. All of these economies still have slack in their labour markets and are experiencing either slowing consumer price inflation or high levels of imported inflation due to currency weakness. These forecasts suggest a manageable debt burden for those in OECD markets and a benign environment for emerging-market borrowers with hard-currency debts to refinance.

Against the backdrop of a steadying global economy lies the highest level of political risk in years. At the centre of this is Mr Trump's administration in the US. Mr Trump is an unpredictable, thin-skinned and impulsive leader. This makes him a difficult ally for both Republicans at home and the country's allies abroad. It is also leading to a chaotic foreign policy, which, given the US's international reach, has consequences all round the globe. The US is seeking to abdicate its leadership of global geopolitics, as demonstrated by its withdrawal from the Paris climate agreement, its departure from the Trans-Pacific Partnership free-trade deal and Mr Trump's refusal to guarantee US support for NATO's Article 5. This is causing allies such as Germany and Canada to strengthen alliances elsewhere and offering the US's rivals, including Russia and China, the chance to broaden their influence. US consent is also likely to have enabled the Saudi-led boycott of Qatar that began in June. We believe that the shift in US foreign policy poses enormous downside risk to political stability and growth in the global economy. Were the US to withdraw from the North American Free-Trade Agreement (NAFTA), trade tensions with China to escalate into boycotts and embargoes or worse, or the US and North Korea to stumble into conflict under the impression that military action from the other was inevitable, the consequences for the global economy would be broad and severe.

Developed world

The US economy is in relatively good shape, buoyed by rapid employment growth and rising house prices. However, wage growth has failed to take off despite the unemployment rate falling to its lowest level since 2001. We attribute this to a lower natural rate of unemployment, which means we have pushed back the date when we expect a business-cycle downturn by a year, to early 2020. In the period until then, GDP will grow by 2.2% a year, which represents the post-crisis new normal for the US. Europe's ongoing recovery phase will be consolidated over the forecast period, although political risk will remain high. For Japan we forecast growth averaging just 1% a year in 2017‑21. The economy will be constricted by a shrinking workforce, a rising old-age dependency ratio and tight immigration controls. Inflation will remain well short of the Bank of Japan's target of 2%.

Emerging markets

The outlook for emerging markets in 2017‑18 is reasonable, with growth quickening to 4.2% from an estimated 3.8% in 2016. Brazil and Russia, the third- and fourth-largest emerging economies, will both emerge from lengthy recessions, and many will benefit from a double-digit rise in industrial commodity prices. Furthermore, we expect financing conditions to remain relatively benign, albeit subject to occasional episodes of volatility.

In 2017 China is on track to grow by 6.8%, which would be the first acceleration in growth since 2010. However, this growth is continuing to be generated partly through an increase in indebtedness, accompanied by rapidly rising property prices in some cities. We believe that this accumulation of debt, particularly in the corporate sector, is unsustainable, and we think that once the president, Xi Jinping, has consolidated his power at a party conference late in the year, he will sanction policies to rein in credit. Firms in the construction and real-estate sectors will be hardest hit. As a result, we forecast that growth will slow significantly in 2018, to 4.8%, from 6.8% in 2017.

With China losing momentum, India will be Asia's fastest-growing large economy in 2017‑21, expanding at an average annual rate of 7.6%. However, the economy is also going through a painful period. A lending spree earlier this decade has saddled state-owned banks with bad loans. Combined with excess capacity in the steel industry, this will depress corporate lending and investment for some time yet. We expect GDP growth in fiscal years 2016/17-2017/18 (April-March) to average 7.4%, before growth accelerates as the major reform programme led by the pro-business prime minister, Narendra Modi, generates greater benefits, especially in infrastructure and policymaking.

Brazil's emergence from a two-year recession will help to lift aggregate growth in Latin America back into positive territory in 2017. But Brazilian growth will be meagre on a year-on-year basis as the country's damaging and protracted corruption scandal dampens confidence. We have revised up Mexican growth again, to 2.3%; the economy has been resilient in the face of deep uncertainty surrounding US-Mexican relations under the Trump presidency. The risk of weakening relations between the US and the wider region is high. The tenor of US trade and migration policies will be crucial. Our forecasts assume that Mr Trump's actions will largely fail to match his startling rhetoric.

Prospects for rapid economic growth in the Middle East and North Africa (MENA) remain stifled by social unrest, war and terrorism. We expect the Saudi-led boycott of Qatar to last for years, as neither side will be willing to back down. As the situation evolves, the conflict will enter a new phase of tighter economic sanctions on the tiny Gulf state, which will undermine the position of the Qatari emir, Sheikh Tamim bin Hamad al-Thani, and see the economy slide into recession. Elsewhere, we expect a general improvement in the region's economic outlook in 2018‑21. Iran will drive this, owing to growth of over 5% a year. Coupled with the positive impact of a broad commitment to improving business environments, this will enable faster growth. However, our assumption is that oil prices will not be sufficient to enable exporters to restore the expansionary fiscal policies that were in place in 2011‑14. Following a dismal performance by Sub-Saharan Africa in 2016, when growth was the slowest in 25 years, economies will perform better in 2017‑18. Prices for exported commodities will rise, and the weather is likely to be more clement.

Exchange rates

After several years of historic highs, the US dollar has steadily lost value during 2017. We expect this trend to be partially unwound over 2018‑19. Financial markets are overly sceptical about prospects for further Fed tightening. We now expect another 200 basis points of rate increases by early 2020. As financial markets reappraise the interest-rate outlook, the US dollar will once again begin to look more attractive. Nonetheless, we do not expect the dollar to recover to levels seen in late 2016. From 2020 the dollar is likely to resume a weakening trend as the business cycle turns and the Fed begins to cut interest rates.

Commodities

The OPEC production cut agreement has failed to deliver the desired rise in oil prices. We expect the cartel to be forced to extend the deal until the second half of 2018 and to unwind it only gradually, to avoid a disruptive market crash. We expect the price of dated Brent Blend, the international benchmark, to rise to an average of US$52/barrel in 2017 as the market registers a small deficit, before inching back down to US$50.8/b in 2018 as the OPEC deal slowly unwinds and as demand growth slows in the second half of the year, particularly from China.